Sunday, April 21, 2019

Will a volatility collapse lead to a market collapse?

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The "Ultimate Market Timing Model" is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, "Is the trend in the global economy expansion (bullish) or contraction (bearish)?"

My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don't buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.

The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities*
  • Trend Model signal: Bullish*
  • Trading model: Bullish*
* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of the those email alerts is shown here.

The calm before the volatility storm?
In the past week, there have been a lot of hand wringing about the collapse in volatility across all asset classes. Equity investors know that the VIX Index has fallen to a 12-handle, and past episodes of low VIX readings have resolved themselves with market corrections.

The MOVE Index, which measures bond market volatility, has also fallen to historic lows.

Low volatility has also migrated to the foreign exchange (FX) market.

As a sign of the times, Bloomberg reported that Europe will soon see a new short-volatility corporate debt ETF.
The 50 million euros ($56 million) product, ticker TVOL, aims to deliver steady gains so long as markets demand a higher cushion for price swings on speculative-grade debt compared with what comes to pass, or the volatility-risk premium.

This dynamic -- selling volatility when it’s high and waiting for it to deflate -- has spurred the post-crisis boom in financial instruments tied to shorting equity swings. Now it offers ETF traders income in the potentially more-stable world of fixed-income options.

“The premium available has been relatively persistent over the last 10 years,” Michael John Lytle, chief executive of Tabula, said in an email. “Most of the time it has also been larger in credit than in equity.”

The Tabula product tracks a JPMorgan Chase index that simulates the returns of selling a so-called options strangle on a pair of credit-default-swap indexes referencing high-yield markets. The underlying index has returned an average 2.9 percent over the past five years but has posted losses over the past 12 months, a period that coincided with the fourth-quarter meltdown in risk assets.
This ETF launch is a classic case of investment bankers feeding the ducks when they're quacking. What could possibly go wrong?

Is this the calm before the volatility storm? What's next? The answer was rather surprising.

The full post can be found here.

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